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Bloomberg Business: January 29, 2016

Specter of Downgrades Haunts Canadian Energy Bonds, G-7's Worst

Investors are steering clear of Canadian energy bonds amid warnings of more credit downgrades as a rout in oil passes 19 months with no end in sight.

Bonds of Canadian oil and natural gas companies are the worst performers among Group of Seven developed nations, with debt of investment-grade producers -- including Encana Corp., Canadian Natural Resources Ltd., Husky Energy Inc. and Cenovus Energy Inc. -- trading like junk. Moody’s Investors Service and Standard & Poor’s have warned that more credit cuts may be forthcoming.

And as global oil benchmarks have rebounded a bit from the lowest levels in more than a decade this month, Canada’s heavy crude is still the cheapest of them all, according to data compiled by Bloomberg, adding to headwinds.

“Spreads will continue to widen out until there’s certainty around the ratings agencies’ view of this,” Ric Palombi, who helps oversee about C$1 billion ($709 million) at McLean & Partners Wealth Management in Calgary, said in a phone interview. Palombi is avoiding energy producers. “The risk-reward would be compelling, but the environment continues to deteriorate.”

Moody’s placed Canadian producers including Encana, Canadian Natural, Cenovus and Husky on review for downgrade in December, noting the potential for multilevel reductions with energy prices "at multi-year lows." S&P lowered the ratings or outlooks on six explorers in October.

In 2015, Moody’s handed out 31 downgrades to Canadian oil and gas producers, and S&P dealt 22, according to data compiled by Bloomberg.

Lowered Forecasts

This month, the ratings companies lowered their forecasts for oil as the price continued to fall amid China’s economic slowdown. West Texas Intermediate crude slipped below $30 a barrel in New York this month for the first time since 2003 and, despite a jump Thursday on news that the Organization of Petroleum Exporting Countries may consider an output cut, it is still down almost 70 percent from a June 2014 high.

Western Canadian Select, derived partly from difficult-to-process bitumen in the oil sands, traded at about $19 a barrel in Edmonton.

While ratings cuts can be seen as lagging indicators that follow bond-market pricing, there are implications. Many bond funds can’t hold high-yield notes, so a cut from investment grade to junk would probably trigger a wave of selling.

“Even though you might think you’re compensated, and -- from an investment point of view -- you might be, you might become a forced seller if these things get downgraded,” Palombi said.

Canadian Natural is focused on remaining investment grade and has options to do so, including by cutting capital outlays, Chief Financial Officer Corey Bieber said last week at an investor conference. The company is rated Baa1 by Moody’s and BBB+ by S&P, both three levels above junk. Bieber said the company has been spending a lot of time with credit-rating companies.

Ratings Discussions

“If they’re looking at a three-notch downgrade, that would be a very different response than reaffirming where we are today or making a one-notch downgrade,” Bieber said. “We haven’t had those conversations.”

The expansion of the company’s Horizon oil-sands mine will significantly improve financial metrics later in 2016, Bieber said in an e-mailed statement. Representatives for Cenovus, Encana and Husky declined to comment.

Oil-market fundamentals have become more dire for companies even since December, Moody’s analysts led by Steven Wood wrote in a report this week. Global oversupply persists with high inventory levels worldwide and additional supplies coming online from Iran are offsetting the reduction in U.S. shale drilling, they said.

‘Boxed Out’

Moody’s sees U.S. crude averaging at $33 a barrel this year, down from a prior estimate of $40, and remaining below $45 through 2018. The oil market may not come into balance until the end of the decade, according to the analysis.

Until prospects improve, producers are going to make concessions to borrow in the bond market, said Ed Devlin, who manages the Canadian investments for Pacific Investment Management Co.’s $1.5 trillion in assets.

“High-quality companies still have access to the capital markets, the bond market, but the yields that they’re borrowing at are obviously much higher,” Devlin said in an interview in Calgary. “Lower-quality, high-yielding companies are basically boxed out.”

The difficulty selling bonds may prompt some companies to turn to equity investors with stock offerings to fund operations, even at depressed prices, said Chris Cox, an analyst at Raymond James Ltd. in Calgary.

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